1. Main Financial Ratios
Author: Jim Riley Last updated: Wednesday 24 October, 2012
Main ratios (introduction)
In our introduction to interpreting financial information we identified five main areas for
investigation of accounting information. The use of ratio analysis in each of these areas is
introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an acceptable rate.
The key ratios are:
Ratio Calculation Comments
Gross Profit
Margin
[Gross Profit /
Revenue] x 100
(expressed as a
percentage
This ratio tells us something about the business's ability
consistently to control its production costs or to manage
the margins its makes on products its buys and sells.
Whilst sales value and volumes may move up and down
significantly, the gross profit margin is usually quite
stable (in percentage terms). However, a small increase
(or decrease) in profit margin, however caused can
produce a substantial change in overall profits.
Operating
Profit Margin
[Operating Profit /
Revenue] x 100
(expressed as a
percentage)
Assuming a constant gross profit margin, the operating
profit margin tells us something about a company's
ability to control its other operating costs or overheads.
Return on
capital
employed
("ROCE")
Net profit before
tax, interest and
dividends
("EBIT") / total
assets (or total
assets less current
liabilities
ROCE is sometimes referred to as the "primary ratio"; it
tells us what returns management has made on the
resources made available to them before making any
distribution of those returns.
Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those resources
invested in fixed assets and working capital.

2. Ratio Calculation Comments
Sales /Capital
Employed
Sales / Capital
employed
A measure of total asset utilisation. Helps to answer the
question - what sales are being generated by each
pound's worth of assets invested in the business. Note,
when combined with the return on sales (see above) it
generates the primary ratio - ROCE.
Sales or Profit
/ Fixed Assets
Sales or profit /
Fixed Assets
This ratio is about fixed asset capacity. A reducing sales
or profit being generated from each pound invested in
fixed assets may indicate overcapacity or poorer-
performing equipment.
Stock
Turnover
Cost of Sales /
Average Stock
Value
Stock turnover helps answer questions such as "have we
got too much money tied up in inventory"?. An
increasing stock turnover figure or one which is much
larger than the "average" for an industry, may indicate
poor stock management.
Credit Given /
"Debtor
Days"
(Trade debtors
(average, if
possible) / (Sales))
x 365
The "debtor days" ratio indicates whether debtors are
being allowed excessive credit. A high figure (more than
the industry average) may suggest general problems with
debt collection or the financial position of major
customers.
Credit taken /
"Creditor
Days"
((Trade creditors +
accruals) / (cost of
sales + other
purchases)) x 365
A similar calculation to that for debtors, giving an insight
into whether a business is taking full advantage of trade
credit available to it.
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they
fall due:
Ratio Calculation Comments
Current
Ratio
Current Assets /
Current Liabilities
A simple measure that estimates whether the business
can pay debts due within one year from assets that it
expects to turn into cash within that year. A ratio of less
than one is often a cause for concern, particularly if it
persists for any length of time.
Quick Ratio
(or "Acid
Test"
Cash and near
cash (short-term
investments +
trade debtors)
Not all assets can be turned into cash quickly or easily.
Some - notably raw materials and other stocks - must
first be turned into final product, then sold and the cash
collected from debtors. The Quick Ratio therefore

3. adjusts the Current Ratio to eliminate all assets that are
not already in cash (or "near-cash") form. Once again, a
ratio of less than one would start to send out danger
signals.
Stability Ratios
These ratios concentrate on the long-term health of a business - particularly the effect of the
capital/finance structure on the business:
Ratio Calculation Comments
Gearing Borrowing (all
long-term debts +
normal overdraft) /
Net Assets (or
Shareholders'
Funds)
Gearing (otherwise known as "leverage") measures the
proportion of assets invested in a business that are
financed by borrowing. In theory, the higher the level
of borrowing (gearing) the higher are the risks to a
business, since the payment of interest and repayment
of debts are not "optional" in the same way as
dividends. However, gearing can be a financially sound
part of a business's capital structure particularly if the
business has strong, predictable cash flows.
Interest
cover
Operating profit
before interest /
Interest
This measures the ability of the business to "service" its
debt. Are profits sufficient to be able to pay interest and
other finance costs?
Investor Ratios
There are several ratios commonly used by investors to assess the performance of a business as
an investment:
Ratio Calculation Comments
Earnings
per share
("EPS")
Earnings (profits)
attributable to
ordinary
shareholders /
Weighted average
ordinary shares in
issue during the year
A requirement of the London Stock Exchange - an
important ratio. EPS measures the overall profit
generated for each share in existence over a particular
period.
Price-
Earnings
Ratio ("P/E
Market price of
share / Earnings per
Share
At any time, the P/E ratio is an indication of how highly
the market "rates" or "values" a business. A P/E ratio is
best viewed in the context of a sector or market average

4. Ratio") to get a feel for relative value and stock market pricing.
Dividend
Yield
(Latest dividend per
ordinary share /
current market price
of share) x 100
This is known as the "payout ratio". It provides a guide
as to the ability of a business to maintain a dividend
payment. It also measures the proportion of earnings
that are being retained by the business rather than
distributed as dividends.